Looking At Inflation And Inflation Policy – Part 1

It would be difficult to find anyone today who has not noticed prices being higher than they were two years ago. Finding anyone who knows how to fix the problem would be at least as challenging.

Understand inflation

Inflation is defined as “a general increase in prices.” If the wheat price rises because the crop is short this year, that is not inflation; that is a specific event like the weather. It isn’t a general increase in the price level. The increase will be measured in the Consumer Price Index (CPI), but it is not part of inflation in the theoretical sense.

Prices are signals.

Under the idea of balancing supply and demand, a new supply arises when prices rise because of a shortage. The higher price is a signal. People seek opportunities, and higher prices often tell them to “Look here.”

Local supply shortages will not cause inflation. Inflation is a general condition.

Money is the one general factor affecting prices.

When there are just enough goods and services and just enough money to allow people to buy goods and services as they appear, prices remain unchanged. Even growth won’t affect it. If supply grows, money grows, and demand grows at the same pace, prices won’t change.

The economy works best when there is just enough supply to meet demand and just enough money to lubricate the transaction. In this condition, the money supply has no effect because all of the money people use to buy goods was earned by supplying those goods. Money is just a way to trade our skills and knowledge for goods we want or need. Supply creates demand.

What happens when unearned money appears?

Understand the economy. It’s just barter. It’s no different from a hunter trading meat for textiles. Money just takes away the inconvenience of having meat while the person who has made your shirt doesn’t want meat today.

It’s all barter. Money is the Intermediary step. With money, you can sell your meat to someone who does want it and use the money to buy the shirt. The weaver can then buy whatever they want using that money. Along the way, everyone has money they received for their contribution. That’s what earned means.

When unearned money appears, what happens? Let’s say it is printed and distributed to the people. We then have the ability to demand things but have contributed nothing to the supply side of the equation.

The vendor can and must raise prices because they expect every input to their product will cost more in the future. Much of inflation is about the anticipation of future prices. We all do it. If I think the price of a durable product will raise in future, I will buy more than I need now to protect myself.

When the government prints and distributes money, it incites two inflation drivers. Higher demand because I have more to spend and an emotional impetus to buy extra now because I expect prices to rise in future. Together new unearned money increases demand, while the expectation of future price increases induces hoarding and shrinks the supply. The balance is maintained by increasing prices.

What happens then

The necessary price signals are disturbed. Demand exceeds supply, and the price signals the need for more supply, but canny suppliers notice the demand is an illusion. There is the same contribution to society by supplying goods and services as before. Prices went up because of the availability of money, and so will the price of inputs. There is no actual shortage of goods. Unless the government intends to give away more money, demand will fall, and supply will eventually catch up even if no new supply appears.

In the interim, many people will be forced to do without things they may want or need. Hoarded goods do not immediately reappear in the marketplace for the less prescient to buy. They do without.

Unearned money causes unearned behaviour.

Behaviour pushes prices. Easy money makes for spending you have not earned.

Renowned economist Milton Friedman commented 50 years ago.

“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

More money available than goods available at the old price means higher prices. That is only possible when no one created goods and earned the money to spend. Stable money arises from making a contribution to the well-being of our fellow Earthlings. Supply is an abstract way to discuss a contribution to society.

Inflation is a measure of political impatience.

It is not so different from when you want a vacation but have no money. You put the trip on your credit cards, and off you go. The government does that too. In the United States, the Federal Reserve prints a truckload or two of money (more likely an electronic transfer) and lends it to the government by purchasing newly minted bonds. The government has money to spend but no money from taxation or other contribution to support it.

There was nothing on the supply side, just more money in the economy.

Debt behaves like a time machine.

It moves money from the future and delivers it in the present. Having money in hand lets people buy things before they have contributed something of equal value to the economy. They pay more in the future because it costs something to operate the time machine. The extra is called interest.

If you buy a house and finance it with a 30-year fixed rate mortgage at 7%, the interest will cost 1.3 times as much as the original mortgage provided. You more than double the price by wanting to buy before you have earned the money needed. The purchase might reduce other costs like rent but buying today instead of tomorrow has a time machine cost. It is not easy to discover if it makes financial sense.

Government debt is the measure of required excess future taxation

For you, is the buy a house today rational? Maybe. It depends on whether or not it offsets other expenses or if you expect the price of a house to rise in the future. Buying now may be the same principle as hoarding paper towels or canned goods. It prevents you from being exposed to ever higher future prices. But you must pay in the future.

Do government giveaway programs provide future value? Maybe, but the value earned is hard to capture to pay the debt. Is it fair for the government to saddle future generations with the price of today’s feel-good spending?

Let’s ask the future generation. I doubt young people will agree to spend more of what they earn in future for interest on unneeded consumption today. If you had to have your children and grandchildren pay off your mortgage with what they will earn, would you be more careful about incurring the debt? Governments are not more careful.

The bit to take away

Governments spending foolishly today means you, your children, and your grandchildren will have less of what you earn in the future

Tomorrow:

  • How do they reduce inflation
  • Reducing demand is only part of the problem.
  • Another layer of the problem involves supply
  • Regulation suppresses supply
  • Reducing the expectation of inflation
  • If it is fixable, who will fix it?

    I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software startup, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning and business matters. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Federal Business Development Bank.

    Be in touch at 705-927-4770 or by email at don.shaughnessy@gmail.com.

 

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